Churning occurs when a financial adviser engages in excessive trading for the purpose of generating commissions. The act of churning is a breach of the adviser’s duty to recommend suitable investments and investment strategies and is considered to be negligent and/or fraudulent conduct.
Over the past decade, the compliance systems that brokerage firms use to uncover sales practice violations by brokers have become more sophisticated and better equipped to uncover churning in an account. When excessive trading or churning is detected, an exception report typically is generated. An exception report is a report that generally is provided to the supervisors, indicating that the compliance software has detected a “red flag.” In general, it is the branch office manager’s responsibility to question the individual broker about the rationale for his or her conduct and determine whether further action is required.
In the typical churning case, the aggrieved customer does not know that churning has occurred in an account unless the value of that account drops, raising concerns. Clients typically do not come into an attorney’s office claiming that their account has been churned. They complain that they do not understand how their account could have dropped in value so much. It is not until the attorney reviews the monthly account documents that he or she notices that large volumes of trades occurred in the accounts without any legitimate explanation. When an attorney suspects churning has occurred in an account, he or she should send the account statements to an expert to confirm the suspicions. This is because, as explained below, churning ultimately is proven through a complicated mathematical equation that determines the annual turnover ratio in the account.